A Tribute to the Thoughts of Another and his Friend"Everyone knows where we have been. Let's see where we are going!" -Another

Saturday, March 21, 2009

New Stimulus Plan

April 19 (Bloomberg) -- Former head of Treasury's Office of Financial Stability, Neel T. Kashkari, was named today as the director of the new Department of Homeland Economic Stimulus. The 35 year old Kashkari said in his first statement to reporters that the much needed stimulus cards will be in the mail as soon as May 1.

"People will be able to spend the entire $400 billion stimulus into the economy by Memorial Day", said the giddy Kashkari, "and the lottery system will ensure that they do."

The emergency stimulus bill rushed through Congress last Tuesday included the creation of the National Stimulus Lottery System, in which specially earmarked 20 year Treasury notes will be sold to the Federal Reserve Bank in order to finance the new $1 billion dollar lottery. 1,000 lucky Americans will have $1 million credited to their new Stimulus Debit Cards as early as July 4, 2009.

In order to qualify for the lottery, one must be in the top 25% of the fastest people to spend all of their $1,500 stimulus money. Fed Chairman Ben Bernanke said in a statement Friday that this incentive should significantly improve the velocity with which this stimulus impacts the economy. He noted that last year's $600 stimulus checks were slow and in some cases invisible to the economy as people either hoarded the money or paid down their debt.

Bernanke explained that the control available through the use of debit cards instead of checks combined with the added incentive of the lottery will totally eliminate this problem.

Included in the stimulus bill was a list of restrictions to the use of the Stimulus Debit Cards. Banks will be blocked from receiving deposits or administering cash through ATM machines with the new cards. Mortgage companies and credit card companies will also be blocked from receiving payments from the cards. "The idea is that we want this money to be spent into the system, not to be hoarded, saved, or used to pay down debt. These things are simply not healthy in our consumer driven economy", said Kashkari.

Bloomberg has figured that the most enterprising recipients should be able to spend their $1,500 within 30 minutes of receiving the cards in order to qualify for the lottery. The recent deflation has brought the price of 52 inch LCD televisions down to only $1,499, which are expect to be a hot item in May.

The new Stimulus Cards will be issued to every adult over the age of 18 with a Social Security number. People without a current mailing address on file with the IRS will have to wait in line at their local post office beginning on May 10. The cards will be imprinted with the recipients name and social security number and are non-transferable.

All recipients are being told to retain the cards even after the $1,500 is spent. If another stimulus is required to jump start the economy, new cards will not be issued. Instead, the Director of Homeland Stimulus will be able to credit new money directly to the original cards. The idea has also been floating through the halls of Congress that the new Stimulus Debit Cards would be a great way to strategically inject stimulus money into very specific areas of the economy that need the money most, like the unemployed, the homeless, and the inner cities.

Critics of the program say that it opens the door to hyper-inflation. But proponents argue that countries like Zimbabwe don't even have this kind of cutting edge technology available to them. They also say that the US dollar cannot be hyper-inflated because there are simply too many of them out there in the world, it is already "too big to fail".

Attention: The above story is not a real news story. It is satire, and it is dated in the future. It is not meant to be a prediction, only to make a couple points and to make you think about the possibilities for hyperinflation.

Antal Fekete writes that bond speculators will enable the Fed to keep the music going much longer than we anticipate. The man is brilliant obviously, but he has yet to explain his serial halving interest rate theory in a manner that I can grasp. Do any of you get it in plain English? There Is More Where This Gift Has Come From

I absolutely love Fekete. But at times he can be positively abstruse. I actually believe that he thinks on an entirely different plane than the rest of us, and he is probably quite frustrated by the difficulty he encounters trying to explain concepts that are so clear to him.

He and I agree on almost everything. I think I agree with his serial halving concept. And he agrees this whole charade will end in a hyperinflationary collapse. The main difference right now seems to be the timing of the collapse. He seems to think that speculators buying TBills can extend the Fed's game for years.

If this were a closed system, within the boundaries of the United States, I think Fekete could be right. But it is not. There are other players involved that are much bigger than the speculators.

China is facing a dilemma. It has the problem of dueling risks. On one hand, it faces the risk of NOT supporting the dollar. And on the other hand it has the considerable risk of HOLDING dollars. Up til now, the former risk has won out. But that is changing. And the actions of the Fed combined with the speculators is RAISING the liquidation (face) value of those older bonds purchased years ago at a higher rate of return. So China will likely see this as an opportunity to unload some of them into a bull market. Once the perceived risk of holding dollars outweighs the perceived risk of supporting the dollar, this will begin in earnest.

Here is the way I understand Fekete's explanation of the serial halving problem. Older 30 year TBills that were issued a few years ago at much higher rates are worth a lot of money right now. They trade at a face value so that the yield is roughly equal to the new issues. If you bought a bond that paid you 5% a year, and now the new issue TBills are paying 2.5%, you can sell your old bond for twice what you paid for it, because that will give the buyer the same yield that a new issue TBill is paying (roughly).

Any entity who issues bonds is borrowing money, the same as a home buyer borrows money. But the difference is that bonds are not like a home loan which you can pay off at any time. They must be repurchased from the marketplace at face value if you want to retire your debt early. A bond contract is meant to give the buyer a guaranteed income stream for a specific period of time. As a bond issuer, you can't just yank that income stream at any time by just giving back the original principle of the loan. If that were the case, then a 30 year bond would be no different than a 1 month bond, as long as plenty of credit was flowing. You could issue 1 month bonds and just keep rolling them over for as long as you needed the money, or you could issue a 30 year bond and pay it off in 1 month if you wanted to retire the debt.

Instead, what you have to do if you want to retire your debt is to buy your bonds back in the secondary bond market. And if interest rates have halved, you only have two options. Either pay TWICE as much as you initially borrowed, or REMAIN STUCK WITH THE DEBT BURDEN until the bond matures.

It is this debt burden that is killing companies right now. For example, a chain of casinos called Station Casinos here in Las Vegas is about to go into bankruptcy. They are making enough money right now to keep operating, but they are not making enough money to BOTH pay for operations and pay the DEBT BURDEN they have accumulated. If rates had not been halved, they could liquidate some of their assets (like maybe sell one of their casinos), and then liquidate the debt. But they can't do that now, because the debt cannot be liquidated for the amount originally borrowed. So their only option is bankruptcy.

Now, think about a new businessman that might want to go into the casino business. Would he want to go into debt right now faced with the continued serial halving that will eliminate his ability to liquidate his debt if he gets into trouble? No. He won't. So it becomes a perpetual spiral. New businessmen avoid the risk during the rate cuts, and existing businessmen in trouble are forced into bankruptcy.

Now think about it from a market perspective. The market senses this liquidation problem, even if each individual actor in the market doesn't understand Fekete's concept. For example, the US Treasury has $11 trillion in outstanding debt. But a lot of that was issued in past years while interest rates were much higher. So if the US were to liquidate its debt right now, it would have to buy those bonds back on the secondary market, at multiples above the original issuing amount. Perhaps it would actually cost $50 trillion to retire our countries' debt today.

So here is the risk that the market senses. There are two ways to retire the debt today. The first would be to print $50 trillion and buy back the bonds. But that would cause hyperinflation and that money you got (even though it had incredible "capital gains") would be toilet paper money. The other way is that they could start Quantitative Easing into the economy which will ultimately cause inflationary fears which will drive the interest rates back up to 5% or whatever. Then, with higher rates restored, they could repurchase those bonds on the secondary market at the original face value. But that, too, has the same effect as the first option, in that you are paid back with less valuable dollars. Maybe they are not as hyperinflated as in the first option, but then again, you didn't make the big capital gains.

So what do you do if you are in the bond market? Do you buy and hold? Do you keep holding what you own? No, you only play for short term gains from the Fed. And what does China do? It gets out, as quietly as possible and hopes to retain some value.

Meanwhile, all this Quantitative Easing does nothing for the real economy as described in the casino example, except that it destroys capital and it destroys the incentives to go into business and take risks. Why borrow capital to take risk in a falling economy? Your debt burden will become harder to service as your income falls. And then if you get into trouble, you can't even downsize and retire some debt. You go bankrupt and lose your initial investment (down payment). Not worth the risk right now.

And he makes the important distinction that interest rates can get halved to infinity. You can literally take an apple and cut it in half, and then cut the half in half, and so on a billion times, until you get down to splitting atoms. And each halving has the same exact effect on existing debt in the form of bonds. It doubles the liquidation value of that debt.

Perhaps it would even cost the US $100 trillion or $1 quadrillion to retire its debt today. I have no idea. I don't know if anyone other than Bill Gross could figure that out. But it is not the US that is most adversely affected by this. It is the private sector that doesn't have the benefit of a printing press at its disposal.

Anyway, that is my understanding of Fekete's argument as he makes it... BUT... I still have some questions for him about this concept.

For example, the bonds issued by a company now in trouble are trading on the secondary market at a lower value now because of the risk of default on those bonds. A lower value means a HIGHER yield than before, not a lower one. So even though the Fed is halving the interest rate it pays for incoming money, and halving the rate that PRIMARY DEALERS can borrow at (directly from the Fed), this does not halve the rate private corporations can borrow new money at.

In fact, troubled corporations pay a much higher rate to borrow new money. So this has the opposite effect on the older bonds they issued at lower rates. Those bonds are now worth less money, because of default risk.

So it could be said that the liquidation value of that old debt has actually DECREASED.

So I am somewhat confused by Fekete's argument, but at the same time it also makes some sense.

Sorry, I'm sure I have just confused you more because I have just confused myself more. It just goes to show that economics is far far far more complicated than most people make it seem.

But one thing is perfectly clear to me. The global marketplace will simply not put up with the US Treasury and the Fed printing money at will to fund their folly, and allow that new money to continually increase in purchasing power in the global market place. It simply won't work that way. All the complexities and invisible-hand forces of the market will work to reverse that trend.

Sinclair is clear as a bell. Thanks for explaining how the apple gets sliced to atoms, going and going but never gone. It just blows my mind that a much larger number doubles no matter how small the amount halved. Yowch.

I always get a kick out of this video. If a dollar was one meter, then our national debt is as wide as the solar system! Think about how big the derivatives complex is! (It is 1/10th of a light year, or as far as light travels in 37 days!) So at the actual size of a dollar, if you laid 1.1 quadrillion of them end to end, it would take the light from the first dollar about 6 days to reach the last one. Note that it only takes light about 8 minutes to reach us from the sun, and only about one second from the moon.

Still fiat and yes that is bad...But, as we know about fiat, given enough trust value will remain. And so it should be. Many things we currently rely on involves trust. Anyone ever studied agency theory in economics, or any other theories involving trust? Trust has a massive value in our society.

I'm not arguing for fiat currency, and I'm sure that given time any fiat money is doomed to fall, but if agreement on a new standard is made now sufficient trust for it will remain and gold is to fall for the coming period.

Martijn, you may have misinterpreted the nature of this proposal. It seems to me to be a renewal of the old SDR, with many expansions.

This sentence at the end of the article:

"If the SDR were backed by real assets, such as a reserve pool entrusted to the IMF, confidence in its value would rise and destabilising currency speculation would be deterred, Zhou said."

I would put the accent above on "real assets", probably meaning a reserve holding of commodities, food, gold and oil. Production or, at least, the potential for production is what they want to back this new high-level monetary unit. If they want to do it right, they would also need insurance against defaults or simply misbehaviour by the participating countries other than promisses: thus gold.

Seems remotely similar to freegold or Sinclair's more centralized gold certificate ratios.

Very good observations. Although I will be surprised if the SDR proposal flies. Jim Sinclair has pointed out the many problems with SDR's. And the IMF is very much a US dollar-centric organization. It is part of "the dollar faction".

Martijn,

That kind of thinking, that this all means gold will go down, is what will make most people miss out on the greatest mass transfer of wealth the world has ever known. I feel really bad for the people that actually have some gold but are selling it right now in order to pay bills. It will be really hard for them to watch where gold goes from here, knowing they recently had some.

Shanti,

If you're out there, I'm still reading that Mundell/Freidman debate. I've got it on my nightstand for nighttime reading. It is a lot to soak in, so I'm reading it one page at a time. It couldn't be more relevant than right now!

Don’t trouble yourself much with the various or particular aspects being put forth with regard to SDRs and their role in a redesign of the international monetary architecture. The fact of the matter is simply this — dialog MUST be couched in terms of the SDR because it is the only politically correct way (at the present time) for international participants of any significant status to publicly advance the discussion of this delicate topic without unduly accelerating the stampede into gold (not to mention recklessly kicking the shins of Uncle Sammy).

Another useful fact of the matter to bear in mind throughout all of this is that the Dollar is, more or less, a creation of New York, whereas the SDR is, more or less, a creation of Washington DC. So, with that said, do you REALLY think that the many international players who are grousing around for a better architecture are truly sincere when they put forth suggestions by which the dollar’s role among international reserves must yield it’s place to the SDR? What on earth would be the point except to temporarily bewilder the village idiots?

The simple, fundamental element to glean from all of these SDR-related discussions is that an overdue paradigm shift is indeed in the works, and even if you can’t quite perceive where it is headed exactly, please know this even if its all you can know: The dollar ain’t gonna be King no more.

(You can also be absolutely sure that nobody’s going to be throwing the Golden Baby out with the overused Dollar-bathwater. And you’ll be amazed at how big and strong he’ll soon grow — a veritable Atlas to bear the economic weight of the world upon his gleaming shoulders!)

I agree. His work is on a level most people can't comprehend. I have tried to rewrite some of it, but I have had difficulty in simplifying it enough. This concept of his is the one I have/had the most difficulty with.

If will give it a try though, I havent before.

Someone said that if you can explain something to a layman you understand it. I'm paraphrasing of course. Let's see what I know. :P

I will do this by way of example.

Imagine a businessman who has $1 milion to invest. Let us say the interest rate at this time 1 is 20%. He has two choices. he could purchase a government bond, which will pay him 20%, or he lend it to a industrialist to buy a machine for that $1000000 with the intent to make more. Let us say the industrialist is able to realise a 40% return if he buys the machine. The industrialist uses 20%( just making it even) to repay his loan and uses the other 20% to pay his worker. So each gets $200k.

At some point in the future, time 2, the interest rate halves to 10%. The industrialist doesnt realise the impact of this rate change and continues to pay his worker $200k . There are two possible scenarios at this point. Either he has a arrangement to keep paying $200k to the investor(case A), or he is able to adjust his payment according to the interest rate(case B).

In case A he still needs a return of 40%. The problem he now has is that another industrialist could buy a machine for $1 million and only needs a rate of return of 20% ( 10% for the investor and 10% for the worker). So market forces would push him down to a 20% rate of return. With 200k going to his worker, the other 200k would need to come out of his savings. ( It is easier to illustrate by introducing the investor than by starting with a industrialist with $1million in capital).

In case B he would need 30%. 200k for his worker and 100k for the investor. Market forces would still push him down to 20% however, so here his loss is simply less.

It might be easier if we look at it from the opposite angle. Imagine for a moment the industrialist is selling something for which the demand is completely inelastic. Lets say the interest rate starts at 10%(time 3). His profit then needs to be 200k ( 100k for his worker and 100k for the investor). If the interest rate were to increase to 20%(time 4), then he would need to double his profit(case C) to repay his loan. 200k for the investor and 200k for his worker( his cost of living has increased after all if interest rates are this high). His initial $1million of capital is now yielding 40%. So... if we compare his profit on $1million dollars at time 4 with time 3, then its as if his capital has doubled. He would have needed $2million to get that kind of profit at time 3, then he does from time 4.

Similarly to how his capital seems to have doubled in time 3 to 4, his capital actually halves in time 1 to 2. ( of course, strictly, not all demand is inelastic and we are ignoring inflation)

In case D, he only needs 30% profit ( 20% for the investor and 10% for the worker). The worker is obviously worse off now, but the investor is still happy.

The other interesting and Important thing worth mentioning is this. It is known that the government is a net buyer of bonds. It is also known that the rate of interest keeps falling due to this. If the investor uses the government manipulation to his advantage then considering this whole picture, what is his best course of action? If he buys bonds initially with his $1million and gets (20%) 200k interest... and interest rates then halve , his bonds are now worth $2million and he still gets 200k(inverse relation between value and yeild of bond). In a falling interest rate environment this is obviously the better choice. So the other insidious part is that this process steals(Diverts) capital from the productive sector of society and makes it flow to the bonds market( where the fun and risk free profits are). Less investment, less production, more consumption, collapse of infrastructure and ultimately the economy( you cannot consume if you do not produce.. mother nature will bite you in the ass at some point, despite the Chinese ;) )

Hehe. This idea is like trying to grasp smoke... very difficult to take ahold of. Even after that try. xD

In conclusion. A rising interest rate environment is not good, since productivity and elasticity can only go so far. A falling interest rate environment leads to the destruction of capital, by various means. What we need is a stable interest rate enviroment. The great thing about gold is not that it provides stable prices ( that is impossible [ and unwanted ;) ] ) but that it provides stable interest rates. This makes long range(time wise) business planning possible and ensures economic growth.

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The above is presented for educational and/or entertainment purposes only. Under no circumstances should it be mistaken for professional investment advice, nor is it at all intended to be taken as such. The commentary and other contents simply reflect the opinion of the author alone on the current and future status of the markets and various economies. It is subject to error and change without notice. The presence of a link to a website does not indicate approval or endorsement of that web site or any services, products, or opinions that may be offered by them.